Finding New Sources of Strategic Advantage

5/2/2005

Now is a good time to take a fresh look at your sources of capability building, according to the new book The Only Sustainable Edge. Book excerpt plus Q&A with coauthors John Hagel III and John Seely Brown.

by John Hagel III and John Seely Brown

Traditional structural sources of advantagefor example, geographic barriers, regulatory barriers, and economies of scalehave eroded. Squeezing savings from operations generally yields diminishing returns. In the search for new sources of advantage, two broad schools of strategy have emerged.

Integrating divergent strategic perspectives. In their influential book, Competing for the Future, Gary Hamel and C. K. Prahalad argued for basing a firm's business strategy on the core competencies of a firm.8 We'll call this argument the core competency school of strategy, which built on a long-established tradition in academic literature. Known as the resource-based theory of the firm, it traces back to Edith Penrose's classic The Theory of the Growth of the Firm.9 As presented by Hamel and Prahalad, this perspective remained very enterprise-centric: Strategic advantage lay in clearly identifying and strengthening core competencies within the firm.

A second school of strategic thoughtlet's call it the leverage school of strategyemerged a few years later with the publication of Co-opetition, by Adam M. Brandenburger and Barry J. Nalebuff, and The Death of Competition, by James F. Moore.10 In these books, strategy focused less on capabilities within the firm and more on opportunities to achieve competitive leverage by mobilizing resources outside the firm. Using different labelsvalue nets and business ecosystemsthese authors drew attention to the strategic advantages that managers can create by shaping and leveraging broader networks of resources beyond their individual enterprise.

Both these schools have vied for the attention of senior executives in the ensuing years. The relative success of the strategies has varied with the ebb and flow of broader business trends. During the exuberance of the late 1990s, the leverage school of strategy seemingly prevailed. A new senior executive positionthe vice president of business developmentemerged to focus on negotiating and managing relationships with strategic business partners. In the economic downturn starting in the year 2000, a back-to-basics zeitgeist ostensibly took hold. As executives turned inward, the core competency school of strategy resurged.11

Both these schools of strategy have merits. Companies can design strategies to fully exploit those internal capabilities that truly distinguish them in the marketplace, and companies can mobilize the resources of other companies to deliver greater value to their customers.

Distinct capabilities remain the basis of strategy but mustrapidly evolve among collaboratorsto remain a source of strategic advantage.

But, as presented, each of these strategies is incomplete. When customers demand more and control more, a company cannot rely solely on its own capabilities, no matter how distinct. Similarly, a company will struggle to mobilize outside resources unless it can offer exceptional capabilities in return. After all, the best enterprises receive so many proposals to collaborate that they will likely form partnerships only with whoever provides truly compelling, unique value. And so the real strategic power comes when a company integrates and extends these two schools of thought, amplifying the value of its distinctive internal capabilities by creatively and aggressively harnessing complementary capabilities from other companies.

Throughout this book, we use the term capabilities broadly to refer to the recurring mobilization of resources for the delivery of distinctive value in excess of cost. Resources refers broadly to both tangible resources (e.g., financial, human, and physical) and intangible resources (e.g., talent, intellectual property, networks, and brands).12 These resources might reside within one's firm, or they might belong to other firms. Mobilization refers to both the practices and the processes required to create and deliver value with the relevant resources available.13 Again, these practices and processes may reside within the firm, but they increasingly extend across other enterprises as well. Thus, resources, practices, and processes may extend well beyond an individual firm, and so the key strategic question for value creation becomes, Which firm can most effectively mobilize resources to deliver value for its customers?

We use the term capability rather than competence because the latter's common usage has tended to denote technology and production skills. For example, we could say that Dell has a distinctive capability in organizing pull-based production and logistics processes on a global scale. In contrast, Nike profits from its distinctive capability in creatively designing and marketing athletic apparel, especially footwear. Disney has a distinctive capability in creating multiple revenue streams from branded characters.

Taking a more dynamic view of capabilities. So far, we have discussed in relatively static terms capabilities as they exist today. As competition intensifies, managers who see their capabilities as static will find themselves rapidly outflanked by more aggressive competitors. The challenge is to accelerate and convert capability building into performance improvement as rapidly as possibleand across enterprises.14 Remember that, according to the leverage school of strategy, competition increasingly hinges on the collective capabilities of business ecosystems or value nets, though we regard these terms as too broad for designing strategy. Consequently, we will later provide more precise descriptions of the various formations that businesses can take to collaborate and to rapidly enhance these collective capabilities.

In this context, integrating the two schools of strategy can help accelerate capability building across enterprises. The core-competencies school emphasizes the need for companies to develop a tight focus on areas of specialization and to be aggressive in seeking to deepen these over time. Companies with this mindset are more likely to seek out ways to accelerate learning. The leverage school drives home the importance of looking outside the enterprise for complementary capabilities. This perspective helps ensure that companies expand their efforts to deepen skills beyond their own boundaries. Rather than looking inward, this perspective reminds us that a lot of the potential for capability building occurs when companies with very different specializations seek to collaborate around common business objectives.

In turn, by stressing capability building, we add a more dynamic aspect to the two schools of strategy. That is, distinct capabilities remain the basis of strategy but must rapidly evolve among collaborators to remain a source of strategic advantage. The competitive edge ultimately depends on a firm's institutional capacity to rapidly deepen its distinctive capabilities and to accelerate learning across enterprise boundaries, rather than simply mobilizing static resources.

Adding this dynamic capability element also helps shift economic analysis from a zero-sum equilibrium model to a positive-sum process model. So, rather than concentrating on dividing the economic pie, participants (whether employees within a single company or firms uniting around common business initiatives) can start focusing on opportunities to enlarge the pie overall. Of course, companies will still want to get their fair share, but distribution will matter less than getting opportunities to create more overall economic value. Moral hazard, cheating, shirking, holdup, holdbacks, principle-agent conflicts, and so forth, will remain very real issues in business; companies should still make institutional arrangements to mitigate these risks. We merely suggest that our more dynamic process view of capability building will put these risks into perspective.

By focusing on accelerating capability building as the source of strategic advantage, we underscore the importance of innovation, but we use the term more broadly than do most executives. Executives usually think in terms of product innovation, as in generating the next wave of products that will strengthen market position. But product-related change is only one part of the innovation challenge. Innovation must involve capabilities; while it can occur at the product and service level, it can also entail process innovation and even business model innovation, such as uniquely recombining resources, practices, and processes to generate new revenue streams. For example, Wal-Mart reinvented the retail business model by deploying a big-box retail format using a sophisticated logistics network so that it could deliver goods to rural areas at low prices.

We mustwatch the edgesof business activity for catalysts to capability building.

Innovation can also vary in scope, ranging from reactive improvements to more fundamental breakthroughs. By emphasizing the acceleration of capability building, we are not restricting our focus to reactive or incremental innovations. Far from it. One of the biggest challenges that executives face is to know when and how to leap in capability innovation and when to move rapidly along a more incremental path. Innovation, as we broadly construe it, will reshape the very nature of the firm and relationships across firms, leading to a very different business landscape.

With the emphasis on capability building, we must look for areas that offer us the greatest potential for specialization and learning. For this reason, we must watch the edges of business activity for catalysts to capability building. As you will see, the edges of the business world, in the various dimensions described earlier, enhance the potential for capability building by bringing together many different specializations from many contexts.

Within this context, we propose that accelerated capability building is the most powerful source of strategic advantage in a global economy characterized by intensifying competition. In fact, accelerated capability building across boundaries is now the only sustainable edge, a proposition that we develop throughout this book. We build on the insights of the dynamic-capabilities school of business strategy by extending it especially across enterprise boundaries.15 The relative pace of capability building matters most. Companies that embrace their edges will develop their own capabilities much faster than those that simply defend and extend their core operations and core markets.

Picture this as the natural extension of the open-innovation model used in product and technology innovation processes.16 Open innovation rewards those who reach beyond their institutional boundaries and tap into specialized expertise distributed across many enterprises to strengthen product innovation. The open-innovation mindset will help you think about accelerating capability building in general, not just about product innovation, but also about process innovation and business model innovation. It builds on the insight widely attributed to Bill Joy, one of the founders of Sun Microsystems, that "there are always more smart people outside your company than within it."17 By embracing this insight, enterprises will start finding creative new ways to connect with a range of other companies to accelerate their own capability building.

Excerpted by permission of Harvard Business School Press from The Only Sustainable Edge: Why Business Strategy Depends on Productive Friction and Dynamic Specialization. Copyright 2005 John Hagel III and John Seely Brown.

John Hagel III is a business strategist and former McKinsey & Company consultant who has advised senior executives around the world for twenty-five years. www.johnhagel.com

John Seely Brown is the former chief scientist of Xerox Corporation and served as director of the Xerox Palo Alto Research Center for twelve years. www.johnseelybrown.com

China, India, and WhatÂ's Next: Q&A with John Hagel III and John Seely Brown

by Martha Lagace, Senior Editor, HBS Working Knowledge

John Hagel III and John Seely Brown recently fielded a few e-mailed questions from HBS Working Knowledge. They argue that tight specialization can be a powerful advantage as long as it is used as a platform for growth.

Martha Lagace: Please tell us a little about your visits to businesses in China and India. What are the latest trends you observed that businesspeople elsewhere should be aware of, and how did these observations influence your thinking on strategy and the development of this book?

John Hagel III and John Seely Brown: Perhaps the most striking observation was the deep sense of urgency expressed by executives in both China and India, shaped by a clear understanding that wage rate arbitrage is not a sustainable source of advantage. Instead, these executives are highly focused on rapid incremental innovation, both in terms of processes and products, and creatively bootstrapping their capabilities wherever possible. We began to see that these executives are mastering new management techniques that can be very helpful in building new forms of strategic advantage.

Q: In his new book, The World Is Flat: A Brief History of the Twenty-First Century, Thomas L. Friedman is stunned by just how rapidly India and China are advancing. This book is a wake-up call to American industry, but what does your book suggest we should actually do about this? Is there a way to turn this threat into an advantage?

A: Tom Friedman provides a compelling perspective on the challenge. A key message of our book is that, if companies act aggressively, they can turn this challenge into an advantage. The capabilities that are being built in these two countries are available to all who understand how to harness them. However, this requires mastering new management techniques to effectively access, mobilize, and more rapidly build these capabilitiestechniques that we describe in detail in our book.

Our biggest concern, however, is that too many American and European executives remain much too complacent about the challenge, meaning that the opportunity does become a significant threat.

Q: The title of your book is The Only Sustainable Edge. Can you tell us what that sustainable edge is?

A: We make the case that getting better faster by working with others is the only sustainable edge. Structural advantages are eroding rapidly. Distinctive capabilities provide temporary advantage, but unless they are aggressively refreshed through rapid incremental innovation, they will be rapidly overtaken by other, more aggressive competitors. Relative capability is no longer the key strategic metric; it is the relative pace of capability building.

We also take to heart [Sun Microsystems co-founder] Bill Joy's observation that "there are always more smart people outside your company than within it." So, if you are serious about accelerating capability building, you will need to focus on the edge of your enterprise and learn how to work more effectively with business partners in ways that help you to get better faster.

Q: Li & Fung, headquartered in Hong Kong and with a network of 7,500 business partners, is clearly an example of a company you admire. What about its strategic focus do you see as cutting edge?

A: Li & Fung is one of the most innovative companies in leveraging the capabilities of specialized business partners on a global scale to add more value to its customers. It has organized a highly flexible global process network that orchestrates activities on a truly end-to-end basis, from the sourcing of fibers to the delivery of finished apparel to retail distribution centers around the world, to create customized supply chains for each item of apparel. These relationships are loosely coupled, so that partners can be quickly brought in and out of specific apparel manufacturing assignments.

At the same time, Li & Fung has invested considerable effort to build shared meaning and trust among its partners, based in part on the potential for rapid capability building, so that it can more effectively collaborate with its partners.

Q: Please discuss specialization and how you define it.

A: Most executives view specialization as a formula for shrinking the business, rather than growing it. In contrast, we view specialization as a prerequisite for profitable and sustained growth. To highlight the difference, we focus on dynamic specializationthe commitment to eliminate resources and activities that no longer differentiate the firm and to concentrate on accelerating growth from truly distinctive capabilities.

If, as we believe, strategic advantage increasingly comes from accelerating capability building, you can be much more effective at this if you are first focused on truly distinctive capabilities. We have been through one wave of specializationthe movement away from conglomerates to focused businesses. We are already in the midst of another wave of specializationunbundling three very different business types that currently reside in most companies: customer relationship businesses, product innovation and commercialization businesses, and infrastructure management businesses.

By the way, specialization does not mean fragmentation of enterprises. At least two of the three business types we discuss have powerful economies of scale and scope that will support significant growth on a global scale.

Q: Specialization seems like a dangerous strategy. After all, the world keeps changing and those who overly specialize might be winners today and losers tomorrow.

A: We would challenge this conventional view. If the primary business challenge is to accelerate capability building, companies must pick their areas of focus carefully and avoid spreading themselves too thin. By specializing more tightly, companies actually enhance their incentives, opportunities, and capabilities for innovation. Again, the key is to pursue specialization explicitly as a platform for growth, rather than viewing it as a defensive strategy.

Q: Your model relies heavily on the importance of collaboration. What are your recommendations for integrating the people side of collaboration: building trust, nurturing talent, dealing with conflict?

A: These are actually all related. Most executives view trust as something that develops on its own timetable. We make the case that trust-building can be accelerated by focusing on appropriate incentives and protection mechanisms. In particular, the prospect of accelerating capability building on both sides of a relationship can provide a powerful foundation for trust and collaboration.

The real test of a collaborative relationship is this: If the relationship ends, will both parties be better off in terms of capability than they would have been if they operated on their own or if they had entered into other relationships instead?

One of the key management challenges in building capability is to turn inevitable friction into productive friction. When people come together with different perspectives, skill sets, and experiences to try to deliver higher levels of performance, they will clash over different approaches. This friction becomes highly productive when the right people are brought together and when they are focused on clear action pointschoices and decisions regarding the best way to achieve aggressive performance targets.

It also helps if they are given broad latitude in terms of the approaches they can take to meet the performance targets and if they can work with appropriate prototypes that can help them to build shared meaning and understanding.

Q: A few years ago, all the buzz was about creating the frictionless economy. Are you saying that was wrong? How can friction ever be considered good?

A: Friction is not only good, it is essential, but it must be made productive. As managers, we are used to viewing friction as wasteful and inefficient, and much of it is. But friction is also an essential element of learning and capability building processes. We rarely internalize a new insight or practice without first challenging and testing it, and that generates friction. As we mentioned earlier, though, managers need to become more adept at techniques for generating productive friction.

Q: How should managers of all sorts of companies take that first step in applying your ideas and honing them to their unique environment?

As we discuss in the book, this is a powerful tool to help make sense of the rapidly evolving business landscape and to align the organization to make more rapid progress in the marketplace. Even before that, we would urge the senior management team (as well as the board of directors) to spend a week together touring key offshoring centers in India and China, meeting with companies that are already active in these areas. During this trip, they should focus on understanding the pace of change, rather than simply taking a snapshot of current capabilities. There is no substitute for this direct and shared experience.

Q: Does your book have policy ramifications?

A: There are significant policy ramifications of our perspective. In fact, we added a Prologue and an Epilogue to more systematically explore some of these ramifications.

Just as enterprises must learn how to compete more effectively by accelerating capability building, nations must do the same. By re-casting public policy issues in terms of their potential to develop talent more effectively, we believe that policymakers will be able to make much better decisions. This focus on talent development is not restricted to education and training policies, but encompasses a broad range of public policy issues, including immigration policy, infrastructure investment programs, intellectual property regimes, financial market regulation, and labor policy. More fundamentally, this will lead to a shift in the "common sense" model for public policy, from a push approach to a pull approach.

Footnotes:

8. Gary Hamel and C. K. Prahalad, Competing for the Future: Breakthrough Strategies for Seizing Control of Your Industry and Creating the Markets of Tomorrow (Boston: Harvard Business School Press, 1994).

10. Adam M. Brandenburger and Barry J. Nalebuff, Co-opetition (New York: Currency Doubleday, 1996); and James F. Moore, The Death of Competition: Leadership and Strategy in the Age of Business Ecosystems (New York: Harper Business, 1996). See also Benjamin Gomes-Casseres, The Alliance Revolution: The New Shape of Business Rivalry (Cambridge, MA: Harvard University Press, 1996). There is a vast literature on the value of collaboration across enterprises. Unfortunately, most of the literature either focuses narrowly on bilateral relationships like strategic alliances or joint ventures or it goes to the other extreme of embracing all conceivable relationships across enterprises under relatively nebulous terms like networks or ecosystems. A good overview of this literature is available in David Faulkner and Mark De Rond, eds., Cooperative Strategy: Economic, Business and Organizational Issues (New York: Oxford University Press, 2000).

11. Business executives in particular have embraced the core-versus-context distinction popularized by Geoffrey A. Moore, Living on the Fault Line: Managing for Shareholder Value in the Age of the Internet (New York: Harper, 2000).

12. In our categorization of intangible resources, we are indebted to Lowell Bryan, Jane Fraser, Jeremy Oppenheim, and Wilhelm Rail, Race for the World: Strategies to Build a Great Global Firm (Boston: Harvard Business School Press, 1999).

13. In this context, we would cite the work of George Stalk and Thomas Hout, Competing Against Time: How Time-Based Competition Is Reshaping Global Markets (New York: Free Press, 1990). Stalk and Hout focus on a set of practices and processes designed to reduce cycle times in the delivery of value to the market, but if the result is to become a capability, these practices and processes must be coupled with specific resources to deliver distinctive value to the market. Otherwise, companies run the risk of falling into the dot-com trap of embracing speed, rather than distinctive value. See also George Stalk, Philip Evans, and Lawrence E. Shulman, "Competing on Capabilities: The New Rules of Corporate Strategy," Harvard Business Review (MarchApril 1992) 5769.

14. A rich strategy literature highlights the importance of dynamic capability building within the firm, starting, most notably, with Joseph A. Schumpeter, Capitalism, Socialism and Democracy (New York: Harper, 1942); Richard M. Cyert and James G. March, A Behavioral Theory of the Firm (Englewood Cliffs, NJ: Prentice Hall, 1963); and Richard Nelson and Sydney Winter, An Evolutionary Theory of Economic Change (Cambridge, MA: Belknap Press, 1982); but then further developed by Robert Hayes, Steven Wheelwright, and Kim Clark, Dynamic Manufacturing: Creating the Learning Organization (New York: Free Press, 1988); and Peter M. Senge, The Fifth Discipline: The Art and Practice of the Learning Organization (New York: Currency Doubleday, 1990). See also Bruce Kogut and Udo Zander, "Knowledge of the Firm and the Evolutionary Theory of the Multinational Corporation," Journal of International Business Studies 24, no. 4 (1993): 625645; Ikujiro Nonaka and Hirotaka Takeuchi, The Knowledge-Creating Company (New York: Oxford University Press, 1995); and D. Teece, G. Pisano, and A. Shuen, "Dynamic Capabilities and Strategic Management," Strategic Management Journal 18, no. 7 (1997): 509533. For a related perspective on dynamic transaction costs, see Richard N. Langlois and Paul L. Robertson, Firms, Markets and Economic Change: A Dynamic Theory of Business Institutions (New York: Routledge, 1995). With rare exceptions, however, these perspectives remain very enterprise-centric, focused on the challenge and mechanisms of building capability within the firm, rather than systematically looking at opportunities to accelerate capability building through relationships with other firms. Even Shona L. Brown and Kathleen M. Eisenhardt, in their excellent book Competing on the Edge: Strategy as Structured Chaos (Boston: Harvard Business School Press, 1998), end up focusing on multiple business units within a single enterprise in their discussion of coadaptation, rather than emphasizing the opportunity to apply this technique across enterprises.